1951, during the korean conflict, president truman also faced anoer battle, between the federal reserve and the treasu over financing the war. how would it be resolved? 1965, lyndon johnson's administration was spending on both a war and a greasociety without raising taxes. the fed was left to fight the resulting inflation alone. the nation's central bank, originally created to protect the banking system against panics acquired more powe to affect the economy than even it imagined at theutset. the federal serve: does money matter? with the help of economic analyst richard gill we'll explore that question on economics usa. i'm david schoumacher.
at t fed's heauaers re in washington, dc closedeliberatioare held by experts who continuously monitor our nancial health and prescribe medies. how did these experts prescribe a remedy that plunged us even deeper in the gat depression? early in the 20th century, american banks operated with little regulation and great vulnerability. in 1907, that vulnerability became apparent when depositors lost confince and demandedir money. e nks coul't get short-termoa and many colpsed. itook a powerful banke j.p. morgan, to endhe 1907 panic. but should an entire country be dependent on an individual's whim? a central bank a lender of last resort, seemed better sotion. just before christmas of 1913, esident wilson sigd e feral reserve act.
it created a federal reserve system. though its real operating powers resided in 12 regional banks its official headquarters was in washington, d.c. merritt sherman, active with the fed since 1926 describes one of its early tools to regulate banking activity-- the discount rate. that was the first tool used whenhe fed was created the discount rate being the rate that is charged to member banks when they need to come in toet additional reserves. and it is raised to restraitheir borrowing, lowered to encourage their borrowing. through world war i, through the roaring twenties most bankers believed the system was safe
and went abouttheir business. then one day it all came tumbling down. october 24, 1929, the greatest stock market crash in history marked the beginning of years of economic devastation. banks failed by e thousands. the fed failed its major test. we asked economist lester chandler for an explation professor chandler the fed was set up to prevent bank failures and avoid depressions, all of whichappened in the 1930s. whatent wrong? within the federal reserve system nody knewwho was too what where the resee act was coerne they had turnedownthe aldrich plan r one cel ba wihes and adopd a system of 1indeenbas.
on topthat they t a fel serve ar at wasupseosomeing centrally, t they coun'cidewho was do what. i'll put it isay. we didt ve very many central bankers in this country in 1914. central baing was not a recognizedssion. fearful that the uted states was not a safe harbo foreign investors withdrew their gold deposits from american nks. in a srt time, $30 million wentverseas. wesked dr. arew brimmer, former member of the federal reserve why gold alarmed the fed. dr. immer, i1931 foreign investors were pulling theigold out of americananks. reserves were being depleted. what does thatoto a bank? what does e reserve do to t to combat
it? for the banking system as a whole if tre's a sigficantreduction in reserves, from whatever source it has to cut back oloans and the exnsion of credit unless ican gesome relief. only t federaleser acting as a central nk can provide more relief. so, in 1931, as the gold flowed to eupend so on thatas a loss in reserves the centbahad to make it up. the fed woulnot stand . itaiseits scouateorceanksase e instido si the sult--foreiginvestors earned more interest and left their money in u. banks. th ended theoldrain. but rag thdiscount re had other, less fortunate, consequences.
if the federal reserve raises the discount rate that tramits a message banksnd toney marke thatt wants be restrictive. for the economy as a whole the result was disastrous. high interest rates discouraged borrowing, choking off business credit. more businesses failed more jobs lost and more banks collapsed. the country was pushed deeper into the great depression. well, professor, if you graded the fed-- a, b, c, d, f-- what would ibe in the 1930s? i would grade it as an "f" applying today's standar probably a "d," applying even the standards-- the most advanced standards of tt day. sure, you can criticize the d. it made mistakes. but what it did wrong was a matter of degree, mostly
rather tn... total mistakes of policy. the men who met around this table were some of the country's most influential bankers. they were the fereserve'sard ofirectors. when they met to changediscouates ey senripplesacross theation. they were practicing a rudimentary form of monetary policy. they were affecting the money suly how important was e money supply? economist chard gill has an anasis. to understand this question, we neesome sense of how t moneyupply affects the economy's general workings and how the fed caaffecthe money supply. this diagram suggests e general natu of the answers theseuestions. theotically, in a depression situation,
the fed should increase reserves available to the commercia banking system-- provide more reserves, as stain the first box. the hope is that banks will lend more credit to businesses thereby increasing the quantity of money in the economy. more money, in turn, should lead to more spending by businesses who have borrowed to invest in new machinery andactories possibly also by consumers like ourselves. more spending, in turn shouldead to higher gnp and moreobs. itay also lead to higher prices though that didn't seem a problem then. 1930s prices were generally falling. when the fed tried to stem the gold outow by raising the discount te in 1931, it was doing the opposite of what this analysis suggests. it made it more difficult for commercial banks to borrow
creating a negative effect on reserves. in fact, during those years of the depression, the country's money supply shnk drastically. a number of economiststoday believe the fed's misdirected policies were a major factor in turning an ordinary downturn into a great depression. we quickly add, however, atoseconomisthe years immediately following cameo a different conclusion.theyoncludedhat there was litthe fed couave do at tse links suggested by the arrows in ouriagram would snap in aerious depression. the fed might make more reserves avaible, but the banks might scared to le them and businesses too frightened to borrow. evenf more money weomehow created opleouldn't spend it. they wou hoa it, have a strong desire for liquidity
in such treacherous mes. hence,ore money might not mean more spending. but without more spending, the final li to raising and employment would necome into ay. in fact,or many years, monetary policy was generallyin dispute in this count particularly when itame to curing business downturns you can lead a horse to water, t you can't make him drink. such was the common opinion. our great new federal reserve system ke tcomy itas supseefen had come upon hard times the banking acof 1935ga theed the authority itee use monetary licy bili thecomy it also ovided t fed win importantool--open-market operatio why, twhen the fed attemed
toise its authority 15ea later ey conict wi the treasury? ouunion is asking itsembe to invest every dollar it can in these bonds. and with god's help and your dollars we'll win this war. in world war ii, asarof its open-market operatio the fed bought treasury bos to help finance the war. fed officials felt that providing that service was essential to victory. as we entered world waii the federal reserve undertook a commitment in january 1942 to support the market for government securities. it would buy and sell all the governme securities anybody wanted to offer on the market to keep inrest rates from rising. the fed ught bondsthe treasury issued
that the publicdidn't buy. dr. brimmer explains more on how open-marketperations affect the economy. open-market operations consist of purchase or sale of government securies. puhases supply reserves.sales reduce reserves. e sees are the basis foexpanding loans and therefore expanding moy and credit. rympornt activity.pumping so much moyinto t ecomy did not lead to inflation because the economy had room to expand anbecause strict conols were imposed on wages and prices. after the alliedictory the treasurynsisted on keeping the same arrangement and the controvey began. the d felt they were merely acting as e treasury's agent it was unclear w ngt would continue. as far as e conduct of motary policy was concerd,
the treasury straitjacketed the fed. why were their interests in conflict? as the economy expanded after the war, the demand for credit rose banks found an opportunity to lend to private companies individuals, and so on. where will they get the reserves the cash to dohat? sell your government securities. ese were very low-yielding-- 2.5%, 2.75% interest. you could at 5%-6% to prite borrowers. sohe banks insurance companies, others, began to sell off govement securities. the federal reserve was committed touy them because oft legacy of war commitment. as it bought securities, it added to ba reserves. that gave the banks e basis for new lending. so theanks would lend, sell securities,
get the desits make more loans. that was aing to an enormous expansion inhe money supply and availability of bank credit. the federal resee was afraid that such an expansion of money and credit would lead to inflation. theninune of 1950, fighting broke out in korea. a limited, but very costly war, it brought out the treasury-fed conflict. the treasury is part of the executive branch. the feral serve is an independent agency create congress, with independence of theolitical pressures from the white house. in that sense, the treasuryould not manda instructions to the federal reserve. chairman thomas p. mccabe believed the fed's role was to restrain inflation. treasury secretary john snyder and president truman
wanted the fed to help finance the war. president truman in his memoirs described the experience he had in 1917. he bought liberty bonds. he didn't know and most people didn't know, that those liberty bondscertainly the series he bought went up andown with markeices. after the war, interest rates rose, nd prices fell and ma people had toell bonds below what they paid for them. truman never forgotthat eerience. he thought the government shouldn't cheat people. truman called the federal open-market committee to the white house for a tongue-lashing. never before had a preside tried so directly to influence fed policy. there was so much misunderstanding on both sides that truman ordered a commission study the matter. rather than let a third party dictate a settlement
the fed and the treasury met on their own to find a solution resulting in e accord of 1951. the federal reserve would be freeo control money and credit without havi to buygovernment securities. the easu agreeto issue someonmarketableonds at carried a somewhat higher intest rate. as in any ttle there wereasuaies. thomas p. mccabe resigned under pressure from truman. he was replaced by william mcchesney martin, a key negotiator of the accord and a treasury undersecretary. following the accord the fed was free to conduct monetary policies unhampered bytreasury constraints. the fed had flexed its muscle and won. using open-market operations in the fifties it proved to be very effective in combating inflation.
the lationship with the treasury became more equaland symbiotic. for more on open-market operations we talked with richard gill. when the fed made open-market puhases of government securities as it diprior to 1951, it was effecvely ireasing the reserves availab the commercial nking system. and thus potentially making more money available the economyn general. here's how it works. the fed purchases, say billion ogornment bon from the tasury. it pays for these bonds by adding 1 biion to thereasury's account. the treasu uses is torite checks toeoe who are providing services tohe government. ese private individuals posit ese checks in tir own commercial banks.
these depositsecome rt of these banks' reserves. with these neweserves, bas can crea more money. is is ry much like pnting-press moy. the fed was sayiatheime of accordats easyoney policy may ha been appropateinepressioyears,buwas longeappropateeconomyshowing ni inflationa tenies. it was also serving noce thatonetary policy mighnot beso weak a olas oe imagined we worked for two centuries to climb this peak of prosperity, but we're only at the beginning of the road to the great society. great society notwithstanding, there was also the matter of fighting a little war
in a place called vietnam. this is the memorial tohat war, an undeclared war whose full cost was kept secret even fm the president's own economic advisers. it posed a chaenge r the fed. could mone policy alone harness the runaway inflation caused byguns-and-butter spending? a guns-and-butter war meant we would try fighng abroad without any majosacrifice of social programs at home. waspending spurred the economy even higher. factories reached full capacity. labor was inemand and could command higher wages. here were sown the seeds of inflation. i eve we can continuehe greatociety while we fight in vietnam. the military chiefs were asking for more money
yet president johnson rejected a tax increase. we asked his economic adviser, james duesenberry, why. we had, after all, just gone through a big program of tax reduction so thaturning around did not appeal to m. but i think a more significant matter was that it brought the issue of the vietnam war intoery sharp political focus. william mcchesney martin then chairman of the federal reserve havery goocontacts with the pentagon anwith the defense producers. and thugh the feraresee system those directors and anches all around the cou the inrmationwas pouring in showing that the economy was heating up. to martin, inflationasmoren a stant threat.
it was a present reality. the federal reserve board decided to fight it. in december 1965 they raised the discount rate. johnson hit the ceiling. he announced publicly he would call bill martin, the chairman of the federal reserve down to the ranch for a tongue-lashing. but raising the discount rate didn't keep inflation from growing. it breaks my heart to go shopping. the war kept growing, too. when neither the administration nor congress applied fiscal restraints, the fed decided to go it alone again. they used an open-market operation. in january 1966, they sold government bonds to tighten up the nation's money supply. interest rates rose dramatically.
soon, any business sensitive to interest rates was caught in a credit crunch. the housing industry was hardest hit. the full effect of the fed's solitary action took hold in early 1967. inflation dropped, but at a terrible cost-- a zero growth rate for the gross national product. to economists, this was an impressive lesson. the fed was very effective in 1966. the discount rate increase and the reduction in the rate of creation of bank reserves drove up market interest rates, reduced investment in residential construction by several billion dollars. that served to offset, from a broad economic point of view the increase in vietnam expenditures. i later, years later asked president johnson what he really thought of that episode.
he said, "you know, andy bill martin was right, but he should have told me about it ahead of time." the war, fought half a world away evespec ofmecan li omeoe titis. the ardonarpolicy significanwe inn, buon agrcost we askedomntatorrichargi o economistse ti w rtt wa ne policy?" certainly by the mid to late 1960s, everybody realized monetary policy was important. even in the old days most people realized that although you can't push on a string you could pull on one. in an economy beset by inflation the reverse links, reduced reserves to less money,
to less spending to lower prices, worked well, perhaps too well. we might get not just lowered prices, but also lowered real gnp. and not just lowered real gnp in general, but higher interest rates and the collapse of interest-sensitive industries like housing and commercial construction. the crunch in the credit crunch of 1966 was for real. monetary policy, it seemed was a lot stronger tool than many had imagined. there was a general rethinking of the whole subject of money and its relationship to the economy. perhaps money mattered in depressions as well as inflations. the keynesian consensus that emerged from the 1930s was beginning to break up. the fed was created as a banker's bank but it has developed over the years into an institution with a much broader
mandate. monetary policy has evolved in response to the demands of history. the great depression showed the fed didn't understand its own power. the korean war underscored the need for the fed's independence. the vietnam era's inflation graphically illustrated both the power and the problems of monetary policy. there's a good deal more to monetary policy. we'll be returning to it again in future editions of economics usa. i'm david schoumacher. captioning performed by the national captioning institute, inc. captions copyright 1986 educational film center